There hasn’t been much discussion of how screwed middle class families with significant medical expenses are going to be by a couple of seemingly minor changes introduced by the Affordable Care Act (ACA). I don’t even recall the screwation of the middle class being discussed as a major goal of the ACA — but surely it must have been, right?

Medical deductions threshold increased to 10% of Adjusted Gross Income

Since the 10% threshold already applies in the Alternative Minimum Tax, this would apparently have no impact on the high earning taxpayers targeted by the much discussed new Medicare taxes on families with income over $250,000. This is aimed squarely at the working middle class (seniors get a four-year holiday on this new rule).

A family with $120,000 in Adjusted Gross Income (AGI), with $15,000 of unreimbursed medical expenses, and living in a taxy state that follows Federal itemized deductions would pay an additional $1,100 or so in income taxes, which is 0.9% of their AGI.

As a percentage of their AGI, high earners will never see an ACA Medicare tax that high (because the new 0.9% Medicare tax applies only to their income above $250,000, not all of their income). The idle rich (that is, those with no earned income but lots of investment income) won’t see an ACA investment tax that high unless they have more than about $8 million of investments in taxable accounts.

Health Flexible Spending Account contributions limited to $2,500/year

This is an important limitation for families with access to only one Flexible Spending Account (FSA) and significant foreseeable medical expenses, such as a family with teenagers who will need glasses and contacts, wisdom teeth removal, and braces.

Such families may also be subject to very high effective marginal rates due to AGI-based credit phaseouts, such as the education credits and the child tax credit, so the loss of the FSA as a means to shelter income from these very high federal marginal rates, state taxes, and payroll taxes is a substantial setback. The damage to a family in the Lifetime Learning Credit phaseout and living in a taxy state might be on the order of $1,500, or possibly 1.25% of AGI for a family with $120,000 AGI..

Combined, these two ACA changes could increase a middle class family’s taxes by a few thousand dollars a year (but only if they have significant medical expenses — healthy families would be unaffected).

I see four mitigation tactics. The first three are obvious:

Max out your FSA each year, especially if your plan has a grace period that overlaps the following year, and especially if the IRS modifies the use-it-or-lose-it rule, which is under consideration.

Max out your traditional 401k to reduce your AGI; this gets you under phaseouts and also reduces the medical deduction threshold.

Bunch medical expenses into one calendar year if you can.

The fourth is less obvious: contribute to a deductible traditional IRA instead of a Roth IRA. Like a traditional 401k, this reduces your AGI and can get you under credit phaseouts. In addition, if you have a major medical emergency, a traditional IRA can be tapped penalty-free to pay for deductible medical expenses. This exception would allow a penalty-free and tax-free withdrawal since expenses over 10% of AGI are deductible. This doesn’t solve the problem that expenses under 10% of AGI aren’t deductible, but it does mitigate your total out-of-pocket expense to cover an unanticipated major medical expense.

For example, take a family with $120,000 AGI and a $30,000 medical bill. They have one FSA that, thanks to the reduced limit, covers only $2,500 of the cost. The next $12,000, thanks to the raised floor, is not deductible, so they have to pay $12,000 out of pocket with no tax relief. That leaves $15,500. They withdraw $15,500 from their IRA, pay almost no penalty and almost no tax.

Why almost? Because they are in the child tax credit phaseout, which is based on AGI rather than taxable income, and effectively taxes their IRA withdrawal at 5%. States that tax IRA withdrawals and don’t follow Federal itemized deductions would also tax the IRA withdrawal. Finally, there’s a weird looping effect here because a Traditional IRA withdrawal will increase your AGI, which increases the deduction threshold.

Many people think they’re not eligible for deductible Traditional IRA contributions when they are. Also see Harry’s previous post The Forgotten Deductible IRA.

The most overlooked case is a couple married filing jointly with about $200,000 of gross income and one spouse not covered by an employer sponsored retirement plan like a 401k. If the covered spouse is over 50, contributes $22,500 to a 401k, has $4,000 of pre-tax insurance premiums, and contributes $2,500 to a FSA, the couple’s AGI is $171,000 and the uncovered spouse is eligible for a $5,000 ($6,000 if over 50) deductible contribution to a spousal Traditional IRA (eligibility starts phasing out at AGI $173,000 in 2012).

The deduction is very nice because this couple is probably in the AMT and may be in a taxy state, so their marginal rate might be over 40%.

[Updated on Nov. 7, 2012 with minor edits.]

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For example, take a family with $120,000 AGI and a $30,000 medical bill. They have one FSA that, thanks to the reduced limit, covers only $2,500 of the cost. The next $12,000, thanks to the raised floor, is not deductible, so they have to pay $12,000 out of pocket with no tax relief. That leaves $15,500. They withdraw $15,500 from their IRA, pay no penalty and almost no tax.

The entire point of the PPACA is that these people will have health insurance, and won’t have to pay $30,000 medical bills.

Also, $120,000 AGI is not anyone’s definition of middle class, except maybe you and Mitt Romney

One way to avoid these pitfalls, at least in part, is to use an HSA. HSA contributions are deductible, and if you contribute through payroll deductions they reduce your income subject to FICA tax. Medical expenses paid for with HSA distributions can’t be deducted on Schedule A, since the contributions were already deducted. You essentially get a deduction on the first dollar of medical expenses, rather than even a 7.5% threshhold to meet.

I believe the high-deductible plans that are required in order to contribute to an HSA are becoming increasingly common. My Fortune Global 100 employer offers three different versions but no “traditional” PPO. Even when a traditional PPO was offered, the premiums were so high that I think few people chose it. I would imagine that anyone with an individual health insurance policy has a high-deductible plan. Anyone with a high deductible plan should contribute as much as they can to an HSA and avoid spending the money saved there for anything but catastrophic health care costs.

I have read both of your articles relating to how much the new health care taxes will affect the high earners, and then the middle class. It is ironic that in today’s environment where fairness in taxation is of such concern that the health care law affects the different income classes in such different ways.

When previous entitlement programs were established (social security and medicare) a tax structure was established that was the same for all potential beneficiaries. And that tax was established so that it would cover the expected future benefit to the potential beneficiaries. Even though the benefits available under these programs were modified by means testing, the taxes to generate the revenues remained flat and the same for all.

The new health care law made no attempt to tax the potential beneficiaries fairly. In fact I believe great effort was taken to make the new law a redistribution of income project. It would have been simple to increase payroll taxes to cover the potential benefits ultimately available to all citizens. But that approach was not taken Instead over 20 different revenue sources were tapped to cover some of the projected costs of the law. The determination of the taxes to be generated from these revenue sources did not appear to be based on what appeared to be fair, but instead on what might be politically acceptable to the masses.

But what the heck. If the new health care taxes had been fair to everyone, you would have been able to cover it in only one article.

All Americans have been screwed by the Affordable Care Act (ACA), regardless of income class. Numerous articles have been written about the death panels, excessive government intrusions, the number of newly insured overwhelming the medical profession, etc. But I believe the most significant negative issue relating to the program has not been discussed. That is its funding.

President Obama indicated the new program must be funded, and criticized Bush for not funding Medicare part D. Yet almost a third of the ACA is funded with smoke and mirror money. That is the $716 billion supposedly shifted over from Medicare.

This $716 billion is suppose to be available because of savings created by the ACA that benefit Medicare. Certainly, approximately $150 billion of the total amount might be available because of cuts to Medicare (the Medicare part D subsidies were eliminated by the ACA.) But most of the remaining savings is due to projected reimbursement rates to doctors providing Medicare services. How could anyone realistically and honestly use reimbursement rates for Medicare that are less than the reimbursement rates for Medicaid to project long term savings? Doesn’t congress pass the “doc fix” every year? But I guess it is a handy tool, to fool us citizens, and to keep CBO projections within desired parameters.

But in the very near future the actual costs will be substantially more than those shown in the dishonest projections. The impact will be even greater deficits and the need for even greater taxation. And maybe everyone’s taxes will have to go up. Yes we are all screwed.

I agree with Matthew! Glad to see someone with common sense here. Most policies max out at $10k or maybe $15k at most, out of pocket for a family, even the high deductible (HSA qualified) ones. Very little chance of spending more, unless you go completely off-plan.

Guessing the exceptions will be a quite minuscule number of middle income taxpayers. Like 1/10 of 1 percent or even less that might get screwed by the ACA in this way.

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